Peer-to-peer, or person-to-person, lending (henceforth “P2P lending”), which emerged in 2004 with the UK’s Zopa platform, is essentially a virtual marketplace that matches supply and demand of funds. The virtual marketplace term is used because P2P lending uses platforms connecting investors/lenders and borrowers in one direct online market that removes layers of intermediation for investors wanting a diversified portfolio of a fixed-income asset class of consumer loans. With P2P lending, such investors do not need to access asset-backed security (ABS) markets.
9 See http://cointelegraph.com/news/114547/hyperrinflationleads-the-number-of-venezuelan-bitcoin-users-to-double, for a brief discussion of Bitcoin use in Venezuela in 2014-2015.
The attractiveness of P2P for borrowers lies in the promise of reduced rates. This is possible because P2P lending’s use of internet platforms reduces costs by eliminating many operational expenses associated with traditional consumer bank loans, such as the cost of maintaining and staffing physical branches. Some cost savings are passed on to borrowers through lower interest rates than those offered by traditional banks. The loans are however unsecured, meaning there is no collateral for lenders to keep if the borrowers do not repay their loans. Thus, P2P investors face losing all their capital if the platform goes bankrupt.10
The P2P lending process varies by platform, but it generally involves some standard steps. First, a prospective borrower submits an application to the platform for
consideration. Borrower applicants enter mandatory information including the loan amount request, maturity choice, purpose for loan, income, employment, and other debt, as well as voluntary information that is posted on the website. Borrowers may also upload documentation verifying income and employment. The platform can then obtain a credit report on the applicant (platforms typically set minimum FICO credit scores) and use this information, along with other data (e.g., loan characteristics), to assign a risk grade to the proposed loan. Depending on the pricing mechanism used, the loan interest rate is usually determined either by the platform itself or via an auction among bidding lenders.11 If accepted, a loan request is posted on the platform’s website, where investors can review all loans. They need not fund entire loans for any prospective borrower, but can instead diversify across borrowers. They can also choose to invest independently or within investment groups. Typically, platforms issue loans in amounts ranging from USD 1,000 to USD 35,000 with maturities of three to five years.
10 For example, the Swedish P2P firm TrustBuddy filed for bankruptcy and froze lenders’ cash in October 2015. For more details, see http://www.telegraph.co.uk/finance/personalfinance/investing/11947261/Peer-to-peer-firm-delisted-from-stock-exchange-after-3m-of-savers-cash-goes-missing.html.
11 See Wei and Lin (2015) for an analysis of Prosper’s switching from an auction to a posted-price mechanism in 2010.
9 11 13 15
07q2 08q2 09q2 10q2 11q2 12q2 13q2 14q2
Quarters Figure 4. Average credit card and P2P interest rates Annualized
Average credit card rate Average P2P interest rate Sources: LendingClub (P2P Rate) and St Louis FRED (credit card rate)
interest rate, per cent
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Interest rate, per cent
Quarters
Average credit card rate Average P2P interest rate (grades A, B) 8
10 12 14 16
Figure 5. Average credit card and P2P interest rates for borrowers A and B (low default risk)
Annualized
Sources: LendingClub (P2P Rate) and St Louis FRED (credit card rate)
The vast majority of P2P borrowing is for credit card and mortgage refinancing, but some P2P platforms focus on other segments of the consumer lending market as well, such as student loans (SoFi, Kiva), and younger borrowers (Upstart). As shown in Figure 4, not every borrower is able to obtain a better interest rate than a credit card one. However, LendingClub12 ranks borrowers from A to G, with A reflecting the lowest probability of
12 LendingClub and Prosper are the two largest P2P lending platforms in the United States.
default. As shown in Figure 5, borrowers with grades A and B, i.e. the least risky borrowers, have consistently been getting better rates through P2P.
Platforms generate profits by closing and servicing loans. Using data from Morse (2015) based on all LendingClub loans issued in the first quarter of 2013, the mean and median origination fees were 2.7 per cent and 3 per cent, respectively. This fee is taken out of the funds provided to the borrower. The platform informs the borrower of the interest rate and the implied APR with the fee added into the calculation, so that the APR reflects the true borrower cost. When fees are paid to LendingClub to service the loan, the platform takes out a 1 per cent service charge before submitting the payments to the investor.
LendingClub also collects delinquency fees from borrowers and collection fees from investors.
P2P lending has received great interest and experienced tremendous growth worldwide in the past few years. By one estimate, in the year 2014 alone in the United States, P2P generated more than USD 8.9 billion in loans, and received more than USD 1.32 billion in venture capital investments.13 Yet, little research has so far emerged on the topic. Indeed, such research is very much needed to understand the welfare implications of P2P across borrower and investor types. As P2P continues to grow, it is also worth investigating the optimality of the lending structure of P2P. Are these middle-to-high income individuals with a probably higher than average tax burden well served by a 3 to 5 year installment loan? Is this the optimal maturity? A few studies have recently emerged on the optimal pricing mechanism in P2P. Wei and Lin (2013) study the event of the P2P platform Prosper unexpectedly moving from price setting via auction (the interest rate is priced at the margin when supply of credit reaches demand) to a coarser system in which Prosper pre-assigns an interest rate based on credit scoring assignment of prospective borrowers into buckets or grades of risk. The authors find that under the pre-set prices, loans are funded with a higher probability at a higher price, but with a higher default rate.
Most importantly, there is the big-picture question of where P2P is headed in terms of consumer finance and whether it could seriously erode the position of traditional commercial banks. So far, most US and UK banks have watched the growth of P2P from the sidelines. This attitude may be a reflection of P2P’s relatively small size. While online lending is growing, its size still remains negligible given that the US consumer credit market is worth more than USD 3,000 bn. Moreover, as the business expands, P2P operators will need to find riskier borrowers to lend to. Indeed, they are already doing so, moving into areas such as small business lending where there is an appreciable need. What bankers seem ultimately to be counting on is that P2P will struggle to make this transition. If banks were proven wrong and P2P were to seriously drive activity out of the traditional banking sector, it could have disruptive effects for the standard channels of impact monetary policy has on the economy. At this stage, it is of course too early to quantify how big P2P should be for this to happen.
13 http://cdn.crowdfundinsider.com/wp-content/uploads/2015/04/P2P-Lending-Infographic-RealtyShares-2014.jpg.